Commercial trading, such as trading in financial markets and trading of financial products, typically takes one of two forms: exchange trading and non-exchange trading.
Exchange trading occurs with the assistance of a public exchange, in which buyers and sellers openly advertise availability of trades and the prices at which the trades may be made. Because of the public nature of exchanges, trades of the same items (e.g., the same stock for the same company) that occur at the same time typically occur for the same price or roughly the same price. Stock exchanges like the New York Stock Exchange (NYSE), in which stocks are traded publicly and are available at a publicly-advertised price, are an example of exchange.
Non-exchange trades, on the other hand, are not public and are not advertised, but instead occur privately between two parties. In a non-exchange trade, one party may privately offer a trade to another party and the trade may be executed when the other party accepts, without anyone else being notified of the trade, the item being traded, or the price. The private nature of the trades may lead to trades for the same item at the same time being carried out at different prices when different pairs of parties are involved. In some cases, one seller may offer the same item to different buyers at different prices at the same time, because the privacy of the trading decreases the risk that the buyers will discover the different pricing. Similarly, buyers may receive offers for trades of the same item at the same time from different sellers with different prices. Non-exchange trades are also commonly known as over-the-counter (OTC) trades.
One example of OTC trading is foreign exchange trading, also called FX trading or “forex” trading. In foreign exchange trading, one party may offer to another to trade one form of currency (e.g., one nation's currency) for another form of currency (e.g., another nation's currency) at a rate of exchange between the two currencies set by the seller. Many different banks and other financial institutions engage in foreign exchange trading and the exchange rates for foreign exchange trading may vary widely. A buying or selling party may set exchange rates for each pair of currencies individually, without regard to whether there is consistency in or equivalence between the parties' exchange rates for multiple sets of currencies.
The differences in pricing between parties for OTC trades may create an opportunity for profit through multiple trades of items to multiple parties at different prices. When these multiple trades for profit are carried out in the foreign exchange market, this is known as “financial arbitrage.” Triangular arbitrage is a form of financial arbitrage in which a party trades between three different forms of currency, often with multiple different parties, to realize a profit. FIG. 1 illustrates an example of a triangular arbitrage. In the arbitrage 100 of FIG. 1, a first party begins with US$1 million and receives an offer for transaction 102 from a second party indicating that the second party will trade euros for the U.S. dollars at an exchange rate of 1.35225 USD/EUR. When the first party carries out this transaction 102, the first party possesses 739,508.23. The first party may then receive another offer for a transaction 104 from a third party indicating that the third party will trade British pounds for euros at exchange rate of 0.68211 GBP/EUR. When the first party carries out this transaction 104, the first party possesses £504,425.96. The first party may then receive another offer for a transaction 106 from a fourth party indicating that the fourth party will trade U.S. dollars for British pounds at an exchange rate of 2.00 USD/GBP. When the first party carries out this last transaction 106, the first party again possesses U.S. dollars, but has US$1,008,851.91 following the series of trades, where the first party originally had US$1,000,000, resulting in a net profit from the arbitrage of US$8,851.91.
Profit from arbitrage is possible in part because of the differences in exchange rates for currencies between parties that accompanies OTC trading. In exchange markets, the prices for transactions are similar between parties at a given time, as discussed above. In an OTC market, in contrast, while exchange rates across the market may be generally consistent, small variations in prices that are established by parties create the potential for profits and create the potential for large profits when the volume of a trade (e.g., the amount of currency exchanged) is large.